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Sub-Zero World: Not Much Positive About Negative Rates

Investment Insights

June 2016

Sub-Zero World: Not Much Positive About Negative Rates

“Introducing negative rates has reduced bank profitability. With lower profits and reduced capital, banks are actually less inclined to make loans, which is the exact opposite of the goal of these policies.”

“For economies to function normally, they need positive interest rates and they need capital to be allocated efficiently.”

— David Hoag

David A. HoagPortfolio ManagerLos Angeles office 29 years of experience (as of 12/31/16)

Central banks are experimenting with negative interest rates in an attempt to jumpstart weak economies.

Negative-yielding debt in Europe and Japan makes U.S. bonds attractive on a relative basis.

Portfolio managers David Hoag and Fergus MacDonald warn that negative rates may be causing distortions in asset prices and the economy.

Quantitative easing and negative rates are bound to spark inflationary pressures over time.

The U.S. Federal Reserve is unlikely to introduce negative rates.

Less Than Zero Japan leads the world in the odd new category of government debt that trades at negative yields. Germany and France are a distant second.

Sources: Capital Group, JP Morgan. Data as of 4/29/16.

Central Banks Go Negative in Bid to Boost Growth

Negative interest rates are taking hold around the world even as the Federal Reserve ponders raising rates. Seeking to stimulate economic growth, central banks are pushing the outer limits of monetary policy, aggressively slashing rates below zero and raising questions about the potentially dangerous consequences.

In January, the Bank of Japan deployed a negative rate policy, surprising markets by reducing its deposit rate on excess reserves to –0.10% (the amount charged to commercial banks for parking cash at the central bank). By doing so, it joined the European Central Bank (–0.40%), Denmark National Bank (–0.65%), Swiss National Bank (–0.75%) and Swedish National Bank (–1.25%) taking tentative steps into negative territory.

As the use of this unconventional policy tool expands, the amount of negative-yielding government bonds has soared to more than $7.6 trillion, or about 25% of total sovereign debt outstanding. That’s an increase from roughly zero in the summer of 2014. Japan is by far the negative yield leader with about $5 trillion outstanding. The rest of the pack consists primarily of European countries, including Germany, France, Italy and the Netherlands.

The goal of negative rates is fairly simple — to discourage commercial banks from stockpiling large amounts of cash. By imposing what is essentially a tax on deposits, central banks are prodding commercial banks to increase their lending and investment activities. The approach, in theory, should boost inflation and economic growth as the money is ultimately put to use by businesses and consumers. In reality, however, it doesn’t necessarily work that way. Some critics view it as a last-ditch effort to jumpstart weak economies after a host of other stimulus measures have failed.

An immediate impact of negative rates can be seen in the European banking sector, where share prices have declined sharply since the ECB first went negative in June 2014. While European banks face a raft of other problems — from strict new regulatory requirements to a rise in non-performing loans — negative rates threaten bank profitability by putting severe pressure on net interest margins. To be sure, bank profits have been stunted for years by ultra-low interest rates. But the cost of negative rates, which most banks are reluctant to pass on to their customers, is taking that pressure to a new extreme.

How Low Can They Go? Central banks in Europe and Japan have cut their deposit rates into negative territory, seeking to boost inflation and economic growth. In contrast, the Fed and the BoE remain just above zero.

Source: FactSet, central banks. Data as of 4/29/16.

Banks and Insurance Companies Slammed by Negative Rates

Ironically, a negative rate policy could undermine its own objective by creating an environment in which banks are unable to extend credit due to concerns about their own financial stability. Meanwhile, insurance companies also face a serious challenge as the negative rate environment drives down global bond yields, impairing their ability to match long-term liabilities with long-term assets. Nippon Life, one of Japan’s largest insurers, acknowledged the problem in April, explaining that negative rates would adversely affect sales and profits for the foreseeable future.

Negative interest rate policies are an extension of central bank monetary easing programs. Following the 2008 financial crisis, a number of the world’s major central banks moved aggressively to cut interest rates in an attempt to revive economic growth. With interest rates at or near zero, some of them — including the U.S. Federal Reserve — also started purchasing government bonds in a strategy known as quantitative easing (QE).

Pioneered by the Bank of Japan more than a decade ago, QE has now spread around the world, much like negative interest rates. In March, the European Central Bank expanded its bond-buying program from €60 billion to €80 billion a month. The BoJ, meanwhile, purchases about ¥80 trillion a year of financial assets. The Federal Reserve ended its own QE program in October 2014 after adding more than $3.5 trillion to its balance sheet, much of which is still there.

The next step was the adoption of negative interest rates — except, notably, for the Fed, which chose to move in the opposite direction. The Fed raised rates in December 2015 for the first time in nearly a decade. It remains one of the few major central banks signaling that it will hike rates this year, given an improving outlook for the U.S. economy. However, it is important to note that even in the U.S., where negative rates have not materialized, they are having a significant impact.

Negative rate policies in Europe and Japan are putting enormous pressure on global bond yields, including U.S. Treasuries. With 10-year German and Japanese bonds yielding almost zero, and shorter maturity bonds firmly in negative territory, U.S. Treasuries yielding 1.83% look quite attractive by comparison. The increasing demand for U.S. government bonds is helping to keep interest rates low domestically, despite the Fed’s desire to eventually normalize rates across the yield curve.

The U.S. economy remains relatively healthy — at least compared to Europe, Japan and some emerging markets — which makes it less likely that negative rates would be employed by the Fed. However, the question was broached during Fed Chair Janet Yellen’s testimony to the Senate Banking Committee in February. While explaining that the Fed is not actively considering a negative rate policy, Yellen acknowledged: “We wouldn’t take those off the table, but we have work to do to judge whether they would be workable here.”

Q&A: Negative Rates Bring Unintended Consequences

To provide perspective on the issue, fixed-income portfolio managers David Hoag and Fergus MacDonald shared their views on negative interest rates. In the following Q&A, they discuss the growing use of negative rates, the implications for the global economy and what needs to happen to cure ailing financial conditions around the world.

Even though the Fed has signaled that it may raise rates soon, is there any possibility that rates could go negative in the U.S. at some point as they have in Europe and Japan?

David: U.S. economic growth would have to deteriorate significantly before the Fed might consider it. Other tools are still available if the economy begins to slow down. The Fed raised rates by 25 basis points in December, so it could cut by that amount. It could also do more quantitative easing. I think the Fed would pursue both of those options before resorting to negative interest rates. Also, let’s remember that a major distinction between the United States and other developed markets right now is that the U.S. economy is fundamentally in better shape. It’s not in great shape, but it’s pretty good compared to some other parts of the world.

Is easy monetary policy — the combination of low to negative interest rates and quantitative easing — working to stimulate growth?

Fergus: Introducing negative rates has reduced bank profitability. With lower profits and reduced capital, banks are actually less inclined to make loans, which is the exact opposite of the goal of these policies. Policymakers are exploring other options, such as providing funding to the banks at negative rates. But that might prove to be ineffectual as well, because there might not be much demand for loans in the real economy.

Why are we seeing low demand for credit in the real economy and muted investments by businesses?

Fergus: Businesses are unwilling to make large investments right now because monetary policy is so aggressive that it’s creating uncertainty in the business community. Corporations are focusing on financial transactions to increase their equity values and profitability. They are not doing much real investing. And that’s why we are seeing low productivity and low growth in economies. Growth comes from productive investment. We need to have an environment where businesses and individuals feel confident enough to make long-term investments.

Are negative interest rates in Japan and Europe posing a significant risk?

David: I think so. Negatives rates distort the natural flow of capital throughout the system. These policies penalize savers, robbing them of the income they need from savings, and direct capital to what may be unproductive areas of the economy. For economies to function normally, they need positive interest rates and they need capital to be allocated efficiently. That’s why I think it is highly unlikely that we would adopt negative interest rates in the U.S.

Do you see stepping away from these easy monetary policies any time soon?

David: I don’t think so. Central banks have put themselves in a position where it is not easy for them to back off without causing potentially extreme reactions in markets and their economies. So they will stay committed to these policies even though it is clear that they are having less impact with every additional measure.

What really needs to happen is for governments to implement fiscal reform and stimulus for these economies to turn. It means embarking on large infrastructure projects as well as creating tax and regulatory environments that encourage economic growth. But given the political difficulties, this will happen slowly and in fits and starts. We are in an election cycle in the United States. In Europe, individual governments have to implement fiscal reforms. In Japan, demographics are a huge headwind and unless they implement some kind of immigration reform, I don’t see how they get sustained, long-term growth. So it will take time.

What does it mean for investors?

David: It means investors should expect continued market volatility. Wall Street and the big banks can no longer be the shock absorbers against sharp asset price swings due to increased government regulations. The liquidity that they used to provide is what I call “rented liquidity,” but nevertheless it provided that buffer. Higher volatility does not mean investors should have a bunker mentality and put everything in cash. It means that investors should have a balanced portfolio of investments that can appreciate and provide income over time.

What are the potential implications of these extremely loose monetary policies? In conventional terms, it would lead to inflation, but we have not seen that come through yet.

Fergus: From my perspective, what central banks are doing is inflationary. We’ve seen price inflation in financial assets and in high-end goods — luxury homes, art and other collectibles. We have not yet seen the impact of loose monetary policies come through in consumer price inflation.

China’s slowdown, falling oil prices and a slump in the industrial economy have been deflationary in the short term. But these deflationary forces result in further easing by central banks, and it is just a matter of time before consumer price inflation picks up more meaningfully. Low business investment leading to low productivity will also in time put upward pressure on consumer price inflation. In the U.S. I think it is quite likely we will have inflation creeping higher with continued low real growth. The Fed will then be in a very difficult situation as it will need to decide whether to raise rates due to higher inflation or to keep rates low due to low real growth.

How should investors think about this environment and their investments?

Fergus: Continued monetary stimulus and potentially more fiscal stimulus will eventually be inflationary for consumer prices. Given the comparative strength and liquidity of the U.S. banking system, I think the chances of a deflationary spiral in the U.S. are very low. Therefore, I would favor investments and portfolio construction that protect real purchasing power in an environment of inflation creeping higher. As a fixed-income investor, this results in TIPS being an important component of the portfolio.

Think U.S. Interest Rates Are Low? Think Again. Thanks to negative rate policies elsewhere, U.S. Treasury bonds are essentially high-yield assets, relative to the bonds of other developed nations.

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